Bankruptcy Trustee Can Avoid Tax Lien for Benefit of Bankruptcy Estate

(Parker Tax Publishing August 2020)

A bankruptcy court held that under 11 U.S.C. Sec. 724(a) and 11 U.S.C. Sec. 551, the trustee in a chapter 7 bankruptcy was allowed to avoid an IRS lien on a taxpayer's homestead for unpaid penalties and interest and preserve the value of the avoided lien for the benefit of the estate. However, the court found that the debtor could claim the amount of the avoided tax lien as exempt because, read together, 11 U.S.C. Sec. 522(g) and 11 U.S.C. Sec. 522(c)(2)(B) prohibit a chapter 7 debtor from claiming an exemption in the recovery of a tax lien avoided by a trustee under 11 U.S.C. Sec. 724(a) and preserved for the estate under 11 U.S.C. Sec. 551. In re Tillman, 2020 PTC 213 (Bankr. Ariz. 2020)

Background

Sandra Tillman purchased a home in Prescott, Arizona, in 2015. Bank of America (BofA) held a $371,350 secured first priority lien against Tillman's home. The IRS filed a lien against Tillman's property for unpaid taxes plus penalties and interest. Tillman paid the tax itself, but the penalty remained unpaid as did accrued interest, for a tax lien totaling $24,686. The IRS's lien held a second (but involuntary) lien position against the property.

Tillman filed for chapter 7 bankruptcy in 2019. She claimed a homestead exemption of $150,000 (the maximum amount permitted under Arizona law) in her residence. The chapter 7 trustee objected to Tillman's claimed homestead exemption, but the bankruptcy court allowed it while clarifying that the homestead exemption was subordinate to BofA's mortgage lien and the IRS's tax lien.

In July of 2019, the trustee filed a motion to authorize the listing and sale of Tillman's residence. In December of 2019, BofA moved for relief of the automatic stay so that it could foreclose on the property. The trustee objected because its motion to sell the property was still pending. Tillman objected to BofA's motion because she claimed she was current on her payments and that the bank's interests were adequately protected. The court held a preliminary hearing and continued the hearing to May of 2020.

In February of 2020, the trustee initiated an adversary proceeding seeking a declaration that the trustee could avoid the IRS's tax lien under 11 U.S.C. Sec. 724(a), and that the value of the avoided tax lien would be preserved for the benefit of the estate. The IRS disputed the trustee's ability to avoid the tax lien for the benefit of the estate and Tillman filed a motion to intervene, which the court granted. Tillman subsequently she argued that her allowed homestead exemption removed the property from the estate, and any recovery from the avoided tax lien belonged to her. In April of 2020, the trustee filed a motion for summary judgment regarding whether the trustee could avoid the IRS's tax lien and, if avoided, whether the avoided lien would be preserved for the benefit of the estate or for Tillman, and what rights the IRS held against Tillman's homestead or proceeds from the sale of that property.

Under 11 U.S.C. Sec. 724(a) and 724(a)(4), a chapter 7 trustee may avoid a lien to the extent the lien secures the claim for a penalty, including a tax penalty. If a tax lien is avoided under 11 U.S.C. Sec. 724, then 11 U.S.C. Sec. 551 provides that the lien is preserved for the benefit of the estate, "but only with respect to property of the estate."

An individual debtor can exempt property from a bankruptcy estate under 11 U.S.C. Sec. 522(b). By claiming property as exempt, the debtor removes the property from the estate and places it beyond the reach of creditors. In certain instances, a debtor may exempt property preserved for the benefit of the estate under 11 U.S.C. Sec. 551. Once a trustee avoids a lien that was not voluntarily created by the debtor, 11 U.S.C. Sec. 522(g) allows the debtor to claim the value of the lien as exempt so long as the debtor did not conceal the property. However, the debtor's right to invoke 11 U.S.C. Sec. 522(g) is limited by 11 U.S.C. Sec. 522(c)(2)(B), which provides that exempted property is not liable for any pre-petition debt except for a debt secured by a tax lien.

Tillman argued that she was entitled under 11 U.S.C. Sec. 522(g) to claim an exemption in the avoided tax lien. The IRS agreed and contended that its surviving claim would have to be paid from any distribution to Tillman from the sale of the homestead. Tillman and the IRS contended that, due to Tillman's homestead exemption, her home was not property of the chapter 7 estate and therefore, 11 U.S.C. Sec. 551 did not apply and the trustee could not preserve the avoided tax lien for the benefit of the estate. Tillman and the IRS cited In re Hannon, 2014 PTC 346 (Bankr. E.D. Mass. 2014), a case where the IRS had a lien on all of the chapter 7 debtors' real and personal property. In Hannon, the debtors claimed an exemption on all of the property, but the IRS lien was greater than the value of the property claimed as exempt. The trustee sold all of the property and then sought under 11 U.S.C. Sec. 724(a) to avoid the portion of the IRS's lien attributable to penalties and interest and then to preserve the avoided lien for the benefit of the estate under 11 U.S.C. Sec. 551. The court in Hannon held that under 11 U.S.C. Sec. 522(g), if the trustee avoided the IRS lien on property in which the debtors claimed an exemption, the value of the avoided lien would accrue to the debtors' exemption, not to the estate.

The Arizona bankruptcy court was asked to resolve the following questions, which the parties noted had not been squarely resolved in the Ninth Circuit:

(1) Can the trustee avoid the tax lien under 11 U.S.C. Sec. 724(a) and preserve the value of the avoided tax lien for the benefit of the bankruptcy estate under 11 U.S.C. Sec. 551?

(2) If the trustee may avoid the tax lien, can Tillman claim the avoided tax lien as exempt pursuant to 11 U.S. C. Sec. 522(g)?

(3) If the trustee may avoid the tax lien and defeat Tillman's 11 U.S.C. Sec. 522(g) claimed exemption, can the IRS satisfy its unsecured (but possibly nondischargeable) claim from the exemption proceeds from the sale of Tillman's homestead?

Bankruptcy Court's Analysis

The bankruptcy held that under 11 U.S.C. Secs. 724(a) and 551, the trustee was allowed to avoid the tax lien and preserve the value of the avoided lien for the benefit of the estate. The court further found that Tillman could claim as exempt only the value over and above the BofA mortgage lien and the IRS tax lien. The court concluded that Tillman could not employ the exemption in 11 U.S.C. Sec. 522(g) because she was not entitled to exempt that portion of the value of the property occupied by the tax lien, whether that tax lien was held by the IRS or was avoided and then held by the trustee for the benefit of the bankruptcy estate.

The court rejected the contention that Tillman's home was not part of the bankruptcy estate. The court found that under the Arizona homestead exemption statute, Tillman's allowed homestead exemption removed at most the value of her interest in the homestead up to $150,000. The court further found that Tillman's homestead exemption did not include the value of the property which was encumbered by either the BofA lien or the IRS tax lien. Thus, the IRS's tax lien encumbered property of the estate, and the court found that the trustee therefore could avoid the tax lien under 11 U.S.C. Sec. 724(a) because the tax lien was a lien for penalties and interest as described in 11 U.S.C. Sec. 724(a)(4).

The court said that the next question was whether the avoided IRS lien was preserved for the benefit of the estate or Tillman, and what rights were held by the IRS after its lien was avoided. The court observed that, on its face, 11 U.S.C. Sec. 522(g) appeared to allow a debtor to exempt any avoided penalty lien. However, the court found that 11 U.S.C. Sec. 522(c)(2)(B) blocked Tillman's ability to co-opt the otherwise avoidable tax lien.

The court found that liens for tax penalties and interest on those penalties may be avoided under 11 U.S.C. Sec. 724(a), but only for the benefit of the estate's creditors. In the court's view, to hold otherwise would enable debtors to wrongfully fail to pay taxes and then use 11 U.S.C. Sec. 522(g) to claim the avoided tax penalty lien for themselves and to the detriment of their creditors. The court said that this was not what 11 U.S.C. Sec. 724(a) was intended to accomplish, nor what 11 U.S.C. Sec. 522(c)(2)(B) mandates. According to the court, read together, 11 U.S.C. Sec. 522(g) and Sec. 522(c)(2)(B) prohibit a debtor from claiming an exemption in the recovery of a tax lien avoided by a trustee under 11 U.S.C. Sec. 724(a) and preserved for the estate under 11 U.S.C. Sec. 551. Thus, the court disagreed with, and found that it was not bound by, the conclusion in Hannon that under 11 U.S.C. Sec. 522(g), a debtor's exemption will displace the trustee when the trustee avoids the tax lien on the property and seeks to preserve that tax lien for the benefit of the estate.

The court further held that after avoidance of its tax lien, the IRS held an unsecured (but possibly nondischargeable) claim against Tillman in the amount of the avoided lien. According to the court, if the IRS's now unsecured claim was nondischargeable, it would be no different from any other nondischargeable claim which would have to be paid by Tillman. However, whether the IRS could force payment of its unsecured and nondischargeable claim from exempt proceeds from the sale of Tillman's residence was not an issue that was ripe for determination, as there were no sale proceeds yet available for seizure by the IRS.

For a discussion of individuals in a chapter 7 bankruptcy, see Parker Tax ¶16,130. For a discussion of the discharge of taxes in bankruptcy, see Parker Tax ¶16,160.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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